Resolving Too-Big-To-Fail Banks In The US

 

 

” The issue of size became important in 1984, when the government bailed out Continental Illinois National Bank & Trust (“Continental”), the seventh largest bank at the time. This bailout occurred because of concerns about systemic risk due to the bank’s size. The FDIC infused $1 billion in new capital into the Continental Illinois Corporation, the bank’s holding company, in exchange for preferred stock convertible to 80 percent of the equity. These funds were then downstreamed to Continental as equity capital to recapitalize the bank. When the government bailed out Continental, Stewart B. McKinney, a Connecticut congressman, declared that the government had created a new class of banks, those too big to fail (TBTF).2 Ever since this bailout, there has been a belief that certain banks or bank holding companies are TBTF, which we call the “TBTF problem.”

This belief that some banks are TBTF was behind the regulatory response to the financial crisis of 2007–2009, when the government bailed out the biggest banks in the country. Many individuals consider the biggest banks to have largely caused the crisis, and this belief has focused far greater attention on the TBTF problem. Indeed, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) of July 2010 created a new federal receivership process pursuant to which the FDIC may serve as the receiver for big banks whose failure poses a significant risk to the financial stability of the United States. The FDIC’s new authority is intended to eliminate the TBTF problem once and for all.

This paper looks at the historical treatment of troubled banks by the FDIC. It examines how the FDIC resolves troubled banks and the sources of funds available to it in the event resolutions are costly. This examination focuses on the treatment of big versus small troubled banks to assess the importance of the TBTF issue. Given the enormous costs involved in bailing out the biggest banks during the recent financial crisis, we discuss the FDIC’s new receivership process to handle troubled big banks. We then assess whether this process will indeed eliminate the problem of large bank failures.”